Capital gains tax is one of the lowest you’ll ever pay

There are three forms of Investment Income in Canada: Interest, Dividends and Capital Gains. Each Is taxed differently. Here’s a reminder of how smart investors use their knowledge to taxation rates, especially tax on Capital Gains, to protect their returns.

With stocks, you only pay capital gains tax when you sell or “realize” the increase in the value of the stock over and above what you paid for it. (Although mutual funds generally pass on their realized capital gains each year.)

Several years ago, the Canadian government cut the capital gains inclusion rate (the percentage of gains you need to “take into income”) from 75% to 50%. For example, if an investor purchases stock for $1,000 and then sells that stock for $2,000, then they have a $1,000 capital gain. Investors pay Canadian capital gains tax on 50% of the capital gain amount. This means that if you earn $1,000 in capital gains, and you are in the highest tax bracket in, say, Ontario (49.53%), you will pay $247.65 in Canadian capital gains tax on the $1,000 in gains.

The other forms of investment income are interest and dividends. Interest income is 100% taxable in Canada, while dividend income is eligible for a dividend tax credit in Canada. In the 49.53% tax bracket, you’ll pay $495.30 in taxes on $1,000 in interest income, and you will pay $295.20 on $1,000 in dividend income.

Three capital-gains strategies

Three capital-gains strategies

As Canadian capital gains tax is lower than the tax on interest and on dividend income, capital gains is a very tax-advantaged form of income. However, since most investors in 2016 have income of all three types, here are three strategies for structuring investment portfolios to minimize the tax burden.

1. It is usually best to hold any common shares outside of an RRSP (as dividend income and capital gains taxes are taxed lower than interest income), and interest-paying investments in an RRSP.
2. More speculative investments are best held outside of an RRSP. If investors hold them in an RRSP and they drop, investors not only lose money, but they can’t use the losses to offset any taxable gains from other investments.
3. Regarding mutual funds outside an RRSP, the main consideration is that mutual funds make annual capital gains distributions even if investors continue to hold the fund units. Investors then pay Canadian capital gains tax on half of any realized capital gains. So you are best to hold mutual funds in an RRSP and common stocks outside. You won’t realize capital gains on common stocks until you sell.

A properly structured investment portfolio can let you take advantage of the low tax rate on capital gains and dividend income while sheltering your higher-taxed interest income in your RRSP. If you make dividends or capital gains in an RRSP, you gain the tax shelter of the RRSP, but when you withdraw the funds from your RRSP they are taxed at the same rate as interest income. This means you would lose out on the lower tax rates offered.

Bonus Tip: Should you be selling your stocks in the first place?

Stock prices tend to move in short spurts, interrupted by lengthy periods when they mainly move sideways. For this reason, sometimes investors who only focus on price, rather than the fundamentals of their investments, may make changes just for the sake of change.

Selling stocks because you are bored with them is not the kind of mistake that brings immediate losses, but it’s sure to cut deeply into your long-term returns. The reason is that the market’s top performers can bore you to tears for months or years at a time. However, even though they may go sideways for a long time, these stocks may then set off on a big rise. If you sell out of boredom, you would miss that rise.

Use these three tips to see if you should be selling your stocks in the first place.

1. Be quicker to sell low-quality stocks, and slower to sell shares of high-quality stocks.
2. Before you sell, ask yourself this: does the stock have a poor fundamental outlook? Or do you want to sell because it just isn’t going up fast enough (see boredom above)?
3. Avoid portfolio tinkering, especially when it comes to selling stocks that you feel have gone up too far and too fast. To succeed as an investor, you need a big winner in your portfolio from time to time. One key fact about big winners is that they tend to go up further and faster than most investors expect, and they keep doing it for years if not decades.

Note: This article was last updated on June 20, 2016.

Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This post originally appeared on TSINetwork and is published here with permission.